Lucas Explains Whole Life Insurance

~ 2300 words, ~ 12 min reading time

About 15 years ago, I was introduced to the Infinite Banking Concept when I met Nelson Nash and his wife at the Mises Institute. He was giving out free copies of his book Becoming Your Own Banker. When I read it, I decided (1) it sounded very interesting and (2) I didn’t understand the thing at all, because I was unfamiliar with whole life insurance. So, all the examples just felt totally made up. And that was where I was for a long time. Then, just recently, I ran across this article by Robert P Murphy. He provided a key insight that let me understand how whole life insurance works. Here, I will share that with you in my own way – though reading Murphy’s article is also certainly worthwhile.

The Infinite Banking Concept

The basic idea behind infinite banking is that you can use whole life insurance as a saving instrument from which you can make withdrawals and take loans. Nash’s book shows that this is typically superior to simply saving using Certificates of Deposit (and certainly beats borrowing from a bank!) or something like that as long as you’re dealing in a reasonably long time frame.

Unlike term life insurance, whole life insurance builds up a “cash value”, which you’re allowed to access – in part or in whole – permanently or temporarily – before you die. And that’s really the key to the whole thing.

Nash’s book includes lots of tables showing the amount of cash value that builds up over time in different types of policies, and shows how you could access that cash to do things like give yourself a car loan, pay for retirement, pay for your kids’ college, etc. (Note: a lot of Infinite Banking is about carefully designing a whole life policy so that it builds cash value quickly while keeping the tax benefits that life insurance provides.)

The natural question I had: how does this cash value thing really work? I’m familiar with term life insurance – where you pay a (at my age, small) premium and if you happen to die in the agreed upon term, the life insurance company will give your beneficiaries a bunch of money. To understand whole life, then, it seemed I really just needed to get my mind around the “cash value”.

Cash Value Explained Badly

The typical explanation for cash value goes something like this… “Each year, we put part of your premium into accumulating cash value while the rest pays for the death benefit.” (from insurance companies) Or “Whole life insurance is a combination of an expensive insurance policy with a mediocre savings plan.” (from critics like Dave Ramsey)

This leads to a natural question: HOW MUCH of my premium is going into cash value each year? If you look for this answer, you can’t really find it. But, hey, I have Excel. I can make some assumptions and figure it out, right?

Wrong. All my attempts to do this ended up making no sense. Cash value doesn’t accumulate the way that you’d expect, say, money in a savings account to. It grows – but the rate of increase in the growth isn’t consistent. True, that’s probably because the % of your premium that goes into the cash value changes over time.

So, I recently used information I got from statefarm.com (which is the ONE insurer I could find that would give me a detailed statement of cash value over time without me having to give them my contact information – I am very averse to receiving sales calls…) to try to tease things out. With the premiums and cash value structure I got from State Farm, I could assume a rate of return on cash value, and then find out what the implied death benefit premiums were. Unsurprisingly, I found that the death benefit premium went up over time. This is what I’d expect. Since you get the death benefit when you die, you’re going to pay more for it if you’re closer to death. But, there were a couple surprising things: (1) The premium for the first couple years was ENORMOUS. Is it really that common for people to take out life insurance policies just before they commit suicide, so that your odds of death in year 1 are so big that a basic whole life policy should accumulate $0 of cash value for a couple years? (2) the premium rose at an increasing rate (not surprising) until you hit age 85, at which point the premium rises at a DECREASING rate. Okay, so I’m a LOT more likely to die at 85 than at 84 (I’ll grant that), but only a LITTLE more likely to die at 95 than 94? That feels a bit… wrong. But, I suppose I’ve not seen the mortality tables…

Another problem with this explanation: it opens whole life insurance up to the worst criticism against it. If you die, your estate does NOT get BOTH the cash value AND the death benefit. It just gets the death benefit. Now, defenders of Whole Life will say things like “if you sell your house, do you expect to get BOTH the equity you built up AND the whole sale price?” (from The Bank on Yourself Revolution by Pamela Yellen) But, this analogy is a bit goofy if we accept the “part goes to death benefit, part goes to cash value” explanation of whole life. When I use a mortgage to buy a house, the part of the home payment that doesn’t go to escrow is ENTIRELY used to pay down the home loan and its interest. I build up equity not because the bank is investing part of the money that I pay them into the house, but because the loan is getting smaller. So, are you saying that when I take out a whole life policy that the insurance company LENT me the policy, and I’m paying it off, so that I build up “equity”? If that’s the case, then why do I get the whole death benefit if I die early?

The better analogy based on the “part death benefit, part cash value” explanation is “buy term and invest the difference”. If I buy a term life insurance policy and also invest in something – stock, bonds, llama farms, whatever. When I die, my heirs get BOTH the life insurance death benefit AND my investments. So, using the “divided premium” explanation DOES make it look like whole life insurance is a big old scam to seize people’s investments when they die.

Good news! As Murphy explains: this explanation is just wrong.

Cash Value Explained Reasonably

Let’s take another stab at explaining cash value.

We’ve already mentioned one key difference between term and whole – the accumulation of cash value. But, there’s another, and it’s absolutely essential in understanding why cash value exists. If you pay your premiums on a term p0licy, you very well may still walk away with exactly $0. How? You don’t die during the agreed term. That is, in fact, what the life insurance company is hoping for.

If you pay your premiums on a whole life policy, you WILL walk away with the death benefit. Guaranteed. Either you’ll get it because you die (and since there is no expiration, you’re pretty well guaranteed to do that at some point), OR you’ll get it because the policy matures (which typically happens when you turn 121, now a days).

What that means, then, is that, from the life insurance company’s perspective, when you buy that $100,000 policy, they are going to be paying you $100,000 unless they can convince you to cancel it. The cash value, then, is really a BUYOUT. It’s an offer from the life insurance company to try to convince you to cancel the policy early so they DON’T have to pay the entire $100,000.

So, why does cash value grow over time? Two reasons: (1) early in the policy, you are least likely to die. Later you’re more likely. This increasing odds of a payout soon makes the life insurance more eager to get you to cancel. (2) early in the policy, you have lots of premiums to pay throughout the remainder of the policy. Later, you don’t. So, early on, if you cancel the policy, the insurance company loses decades of premiums they would receive. They don’t want to do that. But, later, when you’re closer to “death or 121”, you have fewer payments left to make. So, it doesn’t cost them much to have you cancel.

It’s the combination of (1) and (2) that lead the insurance company to want to make you a buyout offer that increases over time.

This ALSO explains why different variations with the same annual premium can provide very different cash values. Consider just 3 options: standard whole life, 10 pay, and paid-up. With the standard policy you pay the premium forever. With 10 pay, you pay premiums for just the first 10 years. with paid-up insurance, you just pay once. Naturally, for a given death benefit, you’ll pay MORE each year if you use 10 pay than a standard policy, and you’ll pay even more for the paid-up policy than you would for a single year’s premium on a 10 pay policy. In effect you’re “paying in advance” for these two structures. It turns out that if you shorten the pay period, you get cash value faster. Why? Because you’ve accelerated reason #2. With a standard policy, I would have possibly 80 years of additional payments coming – this dampens the insurance company’s enthusiasm when it offers me a buyout. But, with a 10 pay policy, I only have 9 additional payments after the first. They’re not losing much if they make a reasonable buyout – and are possibly saving themselves a big death benefit expense. With a paid-up policy, they ALREADY HAVE all the money they’re going to get – so there is no “expected future premiums” to offset their desire to make a buyout offer.

When you die, why don’t you get the cash value AND the death benefit? Because the cash value was a buyout offer to convince you to give up the death benefit. You didn’t take the buyout offer and got the death benefit instead.

So, why can you access this cash value through loans? The reason is fairly simple: the cash value is an asset with a guaranteed value. If I have an asset with a fairly clear value, I can take out a loan using that asset as collateral. Most obviously the case with mortgages and home equity loans, but, with pawn shops, you can do this with literally anything that has a reasonably clear resale value. In this case, it’s the insurance company which provides the asset (the buyout offer), so they’re certainly willing to lend you the money now – and don’t particularly care when you pay it back. At worst, they cancel your policy if the interest on the loan accumulates to more than the cash value is worth. So, no credit check is needed.

What about withdrawals? That’s easy to explain, too. What you’re doing with a withdrawal is taking a PARTIAL buyout. So, you can, for example, sacrifice half the death benefit by taking out half the cash value.

Explaining Dividends

Okay, the last odd thing about whole life insurance (which, weirdly, I never found particularly confusing) is the payment of dividends. When you sign up for a dividend-paying whole life policy, you’ll have the policy itself which offers you a guaranteed cash value over its life. In effect: things are predictable enough on average that the insurance company knows the buyout offers it is willing to make over time. But, you’ll also have claim to dividends which ARE NOT guaranteed. Where do these come from?

Here, we need to get into the old-timey structure of mutual life insurance companies. The basic idea: a bunch of people get together and pay premiums. This money is then invested fairly conservatively so that it can pay any expected expenses (people dying, agents’ commissions, etc.), and probably earns a bit more than that. So, what to do with the “bit more”? As with any business, it should go to the owners. So, who owns the insurance company? In a mutual insurance company, the policyholders do. So, the dividend goes, as it always does, to the owner.

Now, one option that you have is that you can use this dividend to buy more insurance in a paid-up fashion. Since paid up insurance provides a large % of cash value immediately, this is often a reasonable option, and is generally advocated by Infinite Banking/Bank On Yourself.

So, How About Infinite Banking/Bank On Yourself?

I’m going to save my analysis for the next post, but I do want to mention some important points about Infinite Banking/Bank on Yourself.

(1) Infinite Banking and Bank on Yourself advocates typically do not advocate buying just a basic whole life policy. The cash value builds up too slowly to be used for banking purposes. At the same time, they don’t advocate a plain-vanilla paid up insurance policy EITHER. They end up somewhere between using a couple of “riders”. The purposes: build up cash value as fast as possible WITHOUT triggering negative tax consequences.

(2) Nothing in this should be read as me advocating for Infinite Banking or Bank on Yourself. I am not a financial planner or financial advisor. I don’t even have a whole life insurance policy myself, and I’m still not decided whether it makes sense for me to do it. More to come on that. Each of us must make up our own mind. My goal in this post was just to explain some of how cash value actually works. This does, somewhat accidentally, answer one of the big criticisms of whole life insurance (not getting the cash value when you die).